Since 2012, we have been able to contribute to a Roth TSP as well as the longstanding Traditional TSP. This does not mean that we have two TSP accounts if we are contributing to the Roth TSP; rather it means that we have two separate balances within our one TSP account. Also, depending on where you are in your career, it might not matter very much which you choose!
Both the Traditional and Roth are tax advantaged; they are just “differently advantaged”.
The Traditional portion of your TSP is funded with pre-tax dollars and grows tax deferred. This means your taxable income is lower while you are contributing, but all of the money (contributions and earnings) will be taxable when you begin withdrawing it.
The Roth portion of your TSP is funded with already taxed dollars. This means that your taxable income is higher when you are contributing, but, if your withdrawals are qualified, there will be no taxes on your withdrawals. In order for a withdrawal to be considered qualified, you must have had the Roth TSP for at least five years and you must be at least 59 ½ years old. If your withdrawals are not qualified, the portion of your withdrawals that are due to earnings will be taxable.
You are not allowed to have two separate contribution allocations; one for the Traditional and one for the Roth. Your contribution allocation will apply equally to both your Traditional and Roth balances. The same is true for interfund transfers that you may make; they must apply to both Traditional and Roth balances.
If you are covered under FERS, government matching contributions cannot go into your Roth TSP balance. Matching contributions are pre-tax and, as such, must go into your Traditional balance. Even if you have been 100% Roth from the beginning, you will still have a Traditional TSP balance.
If you have both Traditional and Roth balances in your TSP account, all withdrawals must be proportional. For example, if your TSP was made up of 80% Traditional money and 20% Roth money and you began taking $1,200 per month, $960 of that contribution would be taken from your Traditional balance and $240 would be taken from your Roth balance.
The rules on rolling or transferring money into the TSP are different between the Traditional and Roth portions of your account. You can move any pre-tax IRA money into the Traditional TSP; however, you cannot move a Roth IRA into the Roth TSP.
So does it make sense to contribute to the Traditional TSP or the Roth TSP? I asked a CPA colleague of mine to take a look at this topic and here’s what he came up with:
To help you envision the way to approach this decision, imagine yourself standing on a Regular FERS timeline at the 57-years-of-age mark. Behind you is your career from age 40 to age 57 and in front of you is your retirement from age 57 until death. What we want to do is compare the future value of the tax savings that you enjoyed while making contributions as an employee (age 40-57) to the present value of the tax savings that you will enjoy as a retiree (age 57 onward). Let’s run through a couple of examples to illustrate this point.
Let’s assume our employee contributes $18,000 to the Traditional TSP each year, is in the 25% marginal tax bracket (ignore state taxes for simplicity and the TSP catch-up) is 40 years old and will retire at 57 (17 years remaining on the job). We will assume a 5% interest factor and we will keep the contribution the same for all 17 years for simplicity. This employee receives a $4,500 tax break ($18,000 x 25%) each year for the 17 years he/she contributes to the Traditional TSP. The future value of $4,500 in annual tax savings at 5% for 17 years from age 40 is $116,281 at age 57.
Now let’s see what this would look like if the same employee chose the Roth TSP. Obviously, the employee receives no tax break for the contributions made, but will pay no taxes on the withdrawals. Let’s assume that this employee’s Roth TSP balance is $600,000 at retirement and the employee decides to skim off $30,000 a year in withdrawals; and remains in the same 25% tax bracket. The 25% tax on $30,000 is $7,500. If this person saves $7,500 a year in taxes in retirement, and we use the same 5% interest factor, it would take over 29 years in retirement to save $116,281 in taxes (in present-value terms). In other words, at this withdrawal rate, the annuitant would be 86 years old before the Roth TSP’s tax savings exceeded the tax breaks enjoyed by the employee with the Traditional TSP.
Where’s the big Roth TSP advantage in this very simplistic example? It’s simply not there.
Increase the withdrawal amount or the tax rate in retirement; or decrease the tax rate during employment and this example could change dramatically in favor of the Roth TSP, especially if the employee wanted to exercise his/her one-time withdrawal option at retirement and pull out $100,000 tax-free for a new car or a vacation home. I chose these numbers to illustrate that the Roth TSP may or may not be a good choice. You may want to consult a qualified financial or tax advisor to look at your specific situation and assumptions.
If you’re late in your career, don’t get sidetracked with the Roth TSP. Just keep on doing what you have been doing with the Traditional TSP and enjoy the tax break. If you’re a youngster who’s 20+ years from retirement, and you can afford to forego the earlier tax break, the Roth TSP may be a great option for you. You have a long time for those earnings to snowball and you’ll never likely regret your decision to contribute to the Roth TSP. I also place a great deal of weight on the “sleep-at-night factor” in the Roth TSP decision. If having a Roth TSP makes you sleep better at night – DO IT. If you’re contributing $18,000 of your salary each year, no matter which path you choose with the TSP, you will come out way ahead of the pack and will never regret whichever TSP path you choose. As you can see – it really may not matter.
